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Tuesday, September 9, 2014

08/24/2006 Minsky and Debt Structures *

The Dow declined 0.9%, and the S&P500 dipped 0.6%. Economically sensitive issues were under pressure. The Transports dropped 3.4%, and the Morgan Stanley Cyclical index fell 1.6%. The Utilities and Morgan Stanley Consumer indices were unchanged. The broader market returned some of last week’s big gains. The small cap Russell 2000 declined 1.7%, and the S&P400 Mid-cap index fell 2.0%. The NASDAQ100 declined 1.2% and the Morgan Stanley High Tech index fell 1.5%. The Semiconductors dropped 2.7% and The Street.com Internet Index 1.3%. The NASDAQ Telecommunications index added 0.6%, and the Biotechs gained 0.2%. The Broker/Dealers were hit for 3.9%, and the Banks fell 1.3%. With bullion up $7.75 to $622.65, the HUI gold index gained 5.4%.

August 24 – Associated Press: “Big companies bought back a record $116 billion worth of shares in the second quarter, according to a Standard & Poor’s report… The ratings and financial research firm said over 40 percent of the S&P 500 companies reduced their shares outstanding with buybacks in the quarter. The previous buyback record was $104 billion, set in the fourth quarter of 2005…In the past seven quarters, S&P 500 companies have spent $630 billion on buybacks.”

Freddie Mac posted 30-year fixed mortgage rates declined 4 bps to a 20-week low 6.48%, a decline of 32 bps in five weeks - but up 71 basis points from one year ago. Fifteen-year fixed mortgage rates dipped 2 bps to 6.18%, 83 bps higher than a year earlier. One-year adjustable rates declined 5 bps to a 20-week low 5.60%, an increase of 94 bps y-o-y. The Mortgage Bankers Association Purchase Applications Index declined 1.0% this week. Purchase Applications were down 21% from one year ago, with dollar volume down 23%. Refi applications gained 1.3% last week to the highest level since the week of March 31. The average new Purchase mortgage declined to $225,500, while the average ARM declined to $353,600.

Total Money Market Fund Assets, as reported by the Investment Company Institute, jumped $17.5 billion last week to $2.213 Trillion. Money Fund Assets have increased $156 billion y-t-d, or 11.6% annualized, with a one-year gain of $259 billion (13.2%).

Total Commercial Paper surged $30.6 billion last week to a record $1.836 Trillion. Total CP is up $195 billion y-t-d, or 18.2% annualized, while having expanded $258 billion over the past 52 weeks (16.3%).

International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $532 billion y-t-d (20% annualized) and $672 billion (17%) in the past year to $4.578 Trillion.

Currency Watch:

The dollar index gained 0.4% to 85.3. On the upside, the Canadian dollar gained 0.8%, the Sri Lankan rupee 0.7%, and the Paraguay guarani 0.6%. On the downside, the Turkish Lira declined 2.5%, the Colombian peso 2.2%, the South African rand 2.0%, the Polish zloty 1.9%, and the Mexican peso 1.7%.

Commodities Watch:

August 25 – Bloomberg (Ying Lou): “China, the world’s biggest energy consumer after the U.S., will lead global oil demand growth this year, the U.S. Energy Information Administration said. China will consume 7.4 million barrels of oil a day in 2006, an increase of nearly half a million from a year earlier… China will represent 38 percent of the total growth of the world's oil demand…”

August 22 – Bloomberg (Danielle Rossingh): “Coffee rose to a seven-year high in London after derivatives exchange Euronext.liffe said 16 percent of the robusta coffee inventory it tracks was suspended from delivery because of water damage.”

August 22 – Bloomberg (Katy Watson): “Nickel rose to the highest price in at least 19 years on the London Metal Exchange on speculation that global inventories will be eroded by rising demand from makers of stainless steel. Stockpiles of nickel monitored by the exchange have plunged 83 percent this year, and prices have more than doubled.”

August 25 – Bloomberg (Lily Nonomiya): “Japan’s consumer prices rose less than expected in July, damping speculation the central bank will raise interest rates for a second time this year. Government bonds surged the most in almost three years and the yen fell. Core consumer prices climbed 0.2 percent from a year earlier…”

China Watch:

August 24 – International Herald Tribune (Carter Dougherty): “During 20 years in the toy business, Anthony Temple has reveled in the bounty of inexpensive stuffed animals, coffee mugs and resin figurines on sale in China. But a buying trip this year for his company, Rainbow Designs…was a rude awakening. Traveling through the Pearl River Delta north of Hong Kong, Temple found that cost increases - for raw materials, but above all, for labor - dominated every discussion he had with suppliers. Far from being eager to underbid each other, Chinese companies talked about marking up their prices from 5 percent to 10 percent so consistently that Temple…became convinced that these were not simply negotiating gambits. ‘When I went over there, I was under the belief that China is a bottomless pit of cheap product,’ Temple said. ‘When I left, I was not.’”

August 24 – Bloomberg (Yanping Li): “China’s government is targeting annual growth of 11 percent in retail sales in the five years through 2010, the Ministry of Commerce said. ‘An acceleration of domestic trade will help direct industrial production, boost consumption, increase employment and sustain social and economic growth,’ the ministry said…”

August 25 – Bloomberg (Nerys Avery and Yanping Li): “China will curb excessive Growth in investments, ‘strictly’ control land use and lending in the second half of the year, the official Xinhua news agency said…”

August 22 – Bloomberg (Nerys Avery): “Profit at Chinese industrial companies grew 28.6 percent in the seven months through July from a year earlier as surging energy and raw material prices boosted earnings at miners and oil companies.”

August 22 – Bloomberg (Nipa Piboontanasawat): “Hong Kong’s economy grew at a slower pace in the second quarter as record oil costs and rising global interest rates curbed demand for its exports. Gross domestic product rose 5.2 percent from a year earlier…”

August 25 – Bloomberg (Nipa Piboontanasawat): “Hong Kong’s exports rose in July at the fastest pace in four months as the city's port shipped more Chinese-made clothes, toys and electronics to the U.S. Overseas sales climbed 10.7 percent from a year earlier…”

August 22 – Bloomberg (Theresa Tang): “Taiwan’s jobless rate stayed at a more than five-year low in July… The…unemployment rate was 3.88 percent…”

August 24 – Bloomberg (Seyoon Kim): “South Korea’s economy, Asia’s third- largest, will expand 5 percent this year as the government has forecast, Vice Finance Minister Bahk Byong Won said.”

Unbalanced Global Economy Watch:

August 22 – Financial Times (Ralph Atkins): “Eurozone imports from China have overtaken imports from the US, according to data…which highlighted the diminishing impact of foreign trade on eurozone growth. The data from Eurostat, the European Unions statistical unit, highlighted the rapid growth in Chinese imports…”

August 25 – Bloomberg (Laura Humble): “The U.K. economy grew at the fastest pace in two years in the second quarter as consumer spending rose at more than three times the rate of the previous three months. Gross domestic product increased 0.8 percent from the first quarter when it expanded 0.7 percent…”

August 25 – Bloomberg (Fergal O’Brien): “Irish property-related lending accounted for around 80 percent of a 62 billion-euro ($79.2 billion) increase in debt in the last year, according to the central bank. Overall debt rose 27 percent to 288.6 billion in the 12 months through June…”

August 22 – Bloomberg (Simone Meier): “German investor confidence dropped to the lowest in more than five years in August on concern rising borrowing costs and higher taxes will hamper growth in Europe’s largest economy.”

August 22 – Bloomberg (Tasneem Brogger): “Denmark’s employment level increased in the second quarter, led by demand for builders after house prices rose at the fastest pace in more than 20 years… The unemployment rate fell to a 32-year low of 4.5 percent in June…”

August 24 – Bloomberg (Jonas Bergman): “Sweden’s unemployment rate fell to 6 percent in July… The rate fell from 6.3 percent in June and from 6.9 percent a year ago…”

August 24 – Bloomberg (Jonas Bergman): “The price of goods leaving Swedish factories and mines rose 0.3 percent in July from June as the cost of metals and steel increased. Prices of products ranging from food to textiles climbed an annual 3.7 percent…”

August 22 – Bloomberg (Alistair Holloway): “Finland’s jobless rate fell to 6.6 percent in July, the lowest for that month since 1991, reflecting the impact of tax cuts and faster economic growth.”

August 22 – Bloomberg (Thomas Black): “Foreign direct investment in Mexico grew 16 percent in the first half of the year to $8.69 billion, the Economy Ministry said…”

August 24 – Bloomberg (Carlos Caminada and Guillermo Parra-Bernal): “Brazil’s unemployment rate jumped to a 15-month high in July as a rally in the currency eroded profits on exports… The jobless rate in Brazil’s six largest metropolitan areas rose to 10.7 percent from 10.4 percent in June…”

August 22 – Bloomberg (Daniel Helft): “Argentina’s jobless rate fell in the second quarter… The unemployment rate dropped to 10.4 percent from 11.4 percent in the first quarter and from 12.1 percent in the second quarter of 2005…”

August 24 – Bloomberg (Peter Wilson and Allen T Cheng): “Venezuelan President Hugo Chavez signed 28 accords with China valued at $11 billion, including agreements on energy and transportation, as the South American country seeks to lessen its dependence on the U.S. China will invest $2 billion in the country’s oil industry, and another $9 billion to help Venezuela build a railroad…”

Central Bank Watch:

August 21 – MarketNewsInternational: “Price stability risks in Germany have risen again on energy and commodity price increases, while inflationary dangers from the planned value-added tax hike are greater in the context of stronger economic growth, the Bundesbank said in its August monthly report…”

August 23 – Bloomberg (Tracy Withers): “New Zealand company managers expect inflation will be 3 percent in two-year’s time, the highest forecast in 15 years, according to a survey conducted for the Reserve Bank.”

Bubble Economy Watch:

July Durable Goods Orders were up 11.1% from July 2005, with Durable Goods Ex-transportation Orders up 15.1%.

Real Estate Bubble Watch:

Total (New and Existing) July Home Sales were down 12.9% from July 2005. Existing Sales declined 11.2% and New sales sank 21.6%. Year-to-date Total Home Sales are running 6.8% below last year’s record pace (Existing down 5.6% y-t-d; New down 13.5% y-t-d). Thus far, prices are holding up. The Average (mean) Existing Home Prices was up 0.8% y-o-y to $277,000, while the Average New Home Price gained 1.5% to $293,500.

California home sales were down 29.9% last month compared to July 2005. Median Home Prices were up 5.1% ($27,250) from a year ago to $567,360, with Median Condo Prices down 0.9% ($3,660) to $422,590. From the California Realtors Association: “Today’s market is slowing as sellers maintain often unrealistic pricing expectations and buyers have more properties to choose from… In addition, unlike the slowdown we experienced in the 1990s, homeowners today are not under duress to sell due to job losses. The urgency that characterized the market for the last few years is now gone for all but well-priced properties. With inventory levels double that of a year ago, annual price appreciation for the state slowed from the double-digit rates we experienced throughout all of last year to single digits this year… And in some regions of the state prices are down from a year ago. However, with a 7.5-month supply of homes for sale in July, we’re far below the peak of February 1991, when there was an 18-month supply on the market.” The supply of home inventory is up from the year earlier 2.9 months.

Energy Boom and Crude Liquidity Watch:

August 24 – Bloomberg (Greg Chang): “TXU Corp., the largest Texas power producer, ordered $1.7 billion worth of boilers and turbines from General Electric Co. and… Babcock & Wilcox…for proposed power plants… The equipment is intended to be used as part of TXU’s plan to build 11 coal-fired power plants in Texas.”

August 24 – Bloomberg (Stephen Voss): “Royal Dutch Shell Plc’s oil and gas exploration program, the world’s biggest, may suffer from a lack of available drilling rigs in a competitive market, a Shell executive said.”

August 22 – Bloomberg (Jim Kennett): “Transocean Inc.’s Deepwater Nautilus rig should have spent the last two months drilling for oil and natural gas in 8,000 feet of water in the Gulf of Mexico, earning $220,000 a day. Instead, the vessel sat idle in a Texas shipyard. Workers last week finished the latest round of repairs on the Nautilus after Hurricane Katrina tore the 50,277-ton rig from its moorings and Hurricane Rita grounded it... A year after Katrina, the biggest natural disaster ever in the energy business, companies are still tallying the damage done by the hurricanes. The price tag so far, according to two of the world’s biggest insurance brokers and a power-industry group, is $17 billion.”

August 22 – Financial Times (Lina Saigol): “Companies issuing equity in the Gulf have raised almost $15bn during the past 12 months, an increase of more than four times on the previous year in spite of continuing tensions in the Middle East… The dramatic increase has been driven by Middle Eastern companies considering new methods of raising finance… At the same time, investor appetite for shares in Gulf-based businesses has been growing rapidly.”

Climate Watch:

August 22 – Financial Times (Fiona Harvey): “A third of the world’s population is suffering from a shortage of water, raising the prospect of ‘water crises’ in countries such as China, India and the US. Scientists had forecast in 2000 that one in three would face water shortages by 2025, but water experts have been shocked to find that this threshold has already been crossed. Frank Rijsberman, director-general of the International Water Management Institute, said: ‘We will have to change business as usual in order to deal with the growing water scarcity crisis.’”

August 21 - Dow Jones (Tom Sellen): “Normally a twisting, churning river that inspires thoughts of adolescent adventure and riverboat gamblers, drought is turning the ‘Mighty Mississippi’ into a harmless stream that is threatening to cripple shipping. A disruption in river shipping would send ripples through the U.S. economy, as the Mississippi is the largest inland waterway and the jugular through which the U.S. pumps vast amounts of grain and commodities to ports around the world.”

Speculator Watch:

August 22 – Bloomberg (Hamish Risk): “Hedge funds with an insatiable demand for high-yield debt are spawning a new market for loan derivatives in a record year for lending to companies with junk ratings. Credit-default swaps based on loans, which barely existed at the start of this year, have grown to $7 billion, according to data compiled by Lehman Brothers…”

Minsky and Debt Structures:

Last week’s Bulletin delved into the current Financial Structure. I neglected to Credit the Great Hyman Minsky as my inspiration for this line of analysis. I will expand upon the analysis with this week’s focus on the residual – the output - of the Financial Structure: Debt Structures, beginning with pertinent insight directly from the writings of Dr. Minsky (from Inflation, Recession and Economic Policy, 1982).

“In order to understand why our economy has behaved differently since the middle of 1960s than it has earlier in the post-World War II epoch we have to appreciate how the broad contours of the financial structure have changed. The changes in the broad contours of demand have changed the reaction of aggregate profits to a change in investment and therefore have changed the cyclical behavior of the ability of business to validate its debts. The changes in the financial structure have increased the proportion of speculative and Ponzi finance in the total financial structure and therefore increased the vulnerability of the financial system to refinancing and debt validating crises.”

“A thorough research study should examine the changing composition of the assets and liabilities of the various sectors and the implications of this changing structure, as well as changes in financing terms, for the cash flows of the various sectors of the economy. The cash flow structure due to liabilities need then be integrated with the cash flow from assets and the various cash flows due to income production. In particular the changing relations between cash receipts and payment obligations and between payment obligations and the margin of safety need be understood.” (page 49)

“The combined effects of big government as a demander of goods and services, as a generator – through its deficits – of business profits and as a provider to financial markets of high-grade default-free liabilities when there is a reversion from private debt means that big government is a three way stabilizer in our economy and that the very process of stabilizing the economy sets the stage for a subsequent bout of accelerating inflation.” (page 56)

“Innovations in financial practices are a feature of our economy, especially when things go well… But each new instrument and expanded use of old instruments increases the amount of financing that is available and which can be used for financing activity and taking positions in inherited assets. Increased availability of finance bids up the prices of assets relative to the prices of current output, and this leads to increases in investment… In our economy it is useful to distinguish between hedge and speculative finance. Hedge finance takes place when the cash flows from operations are expected to be large enough to meet the payment commitments on debts. Speculative finance takes place when the cash flows from operations are not expected to be large enough to meet payment commitments, even though the present value of expected cash receipts is greater than the present value of payment commitments.” (page 66)

“During a period of successful functioning of the economy, private debts and speculative practices are validated. However, whereas units that engage in hedge finance depend only upon the normal functioning of factor and product markets, unit which engage in speculative finance also depend upon the normal functioning of financial markets. In particular, speculative units must continuously refinance their positions. Higher interest rates will raise their costs of money even as the returns on assets may not increase…

In addition to hedge and speculative finance there is Ponzi finance – a situation in which cash payments commitments on debt are met by increasing the amount of debt outstanding… Ponzi financing units cannot carry on too long. Feedbacks from revealed financial weakness of some units affect the willingness of bankers and business to debt finance a wide variety of organizations… Quite suddenly a panic can develop as pressure to lower debt ratios increases.” (page 67)

A strong analytical case can be made that our expansive Financial Sphere has been operating in the realm of Ponzi Finance Dynamics for some time now – at the minimum going back to the late-nineties technology/telecom Bubble (although my inclination would to date the inception at 1993’s bond/MBS Bubble) which heralded the Mortgage Finance Bubble and the now unfolding Corporate Debt Bubble and Global Credit Bubble. But what, you might enquire, about Minsky’s assertion that “Ponzi financing units cannot carry on too long?” Was he just flat wrong? Or perhaps it is more a case of radical changes to the “broad contours” of the Financial Structure. I’ll argue the latter, and in the process attempt to offer some insight relevant to today’s extraordinary environment.

Although Minsky would certainly recognize the enormity of the past twenty years’ financial evolution, contemporary Credit systems’ capacity to create unlimited finance are completely unrecognizable to the (bank-centric, Fed regulated and restrained global monetary regime) monetary systems he had previously studied and analyzed. Ponzi Finance units these days not only keep on carrying on, they tend to prosper and proliferate to the point of now being deeply embedded in Financial and Economic Structures. This has been possible specifically because of “Wall Street’s” capacity for supplying increasingly enormous quantities of finance at unusually low real and nominal interest-rates.

It is a key premise of Minskian analysis that inflationary booms come to their demise when progressively more unstable Debt Structures eventually run headlong into surging interest rates (determined by the interplay of rising demand for Credit against a limited supply of finance) and attendant marketplace uncertainty and risk aversion. These days, however, borrowing costs are determined much more by Federal Reserve and global central bank policies than by the supply and demand for finance, while marketplace uncertainty is ameliorated by expectations that policymakers will respond immediately to mollify market tumult and economic shocks. Amazingly, even after years of explosive debt growth and leveraged speculation, there are few marketplace symptoms indicating Debt Structure stress or investor angst. What gives?

For one, Minsky’s “big government” as “stabilizer” insights require considerable updating. Today, with the unprecedented ballooning of federal mortgage agency debt and guarantees (Fannie, Freddie, Ginnie Mae, the FHLB, FHA, VA, etc.), a large swath of mortgage finance has been effectively nationalized. Despite risky multi-trillion dollar (and growing) real estate exposures resting tenuously upon slivers (if we’re lucky) of equity, GSE borrowing costs remain only modestly higher than the U.S. Treasury’s. The market has yet to waver from the implicit federal backing of the government sponsored enterprises, and foreign investor and central banker appetite for their paper appears as strong as ever. The entire MBS marketplace essentially trades with the presumption of government support, which goes a long way toward explaining why agency and MBS debt markets are in no way priced as the Ponzi Units they are divorced from “big government.”

And while the U.S. Treasury’s likely backing of agency obligations and ongoing federal deficits have acted as key system “stabilizers,” the Federal Reserve’s role in buttressing the contemporary Credit system is today the most imposing manifestation of runaway “big government.” That “big government” explicitly and implicitly underwrites a large portion of system Credit instruments (including Treasuries, agencies, deposits, MBS, ABS, etc.) while at the same time “pegging” the cost of funds, amounts to the greatest “stabilizer” role in the history of finance. This highly atypical backdrop invited and then nurtured both the unparalleled expansion of market-based Credit instruments, on the one hand, and unprecedented leveraged speculation in these instruments, on the other. Consistent with Minskian analysis, such a backdrop “sets the stage for a subsequent bout of accelerating inflation,” with Serial Asset Bubbles and Untenable Current Account Deficits the prevailing Financial Structure’s most pronounced Inflationary Manifestations.

Further updating Minsky’s “big government” thesis necessitates incorporating the unparalleled foreign central bank accumulation of dollar-denominated debt instruments. This massive and boundless “recycling” of dollar balances back into U.S. securities markets has been an invaluable “stabilizer” force for the dollar, U.S. yields and, hence, U.S. Credit and Economic Bubbles. Certainly, this market circumvention continues to play a paramount role in masking the Ponzi Finance aspects of the U.S. Credit system and asset markets.

But when it comes to masking the fragility of Ponzi Finance, one should keenly direct analysis to contemporary derivatives markets. I’ll this evening propose that the now all-encompassing Derivatives Arena amounts to The Alchemy of Big Government Stabilizers – most prominently, prospective federal government deficits and debt guarantees; central bank telegraphed “pegged” interest rates; and foreign “official” recycling of dollar Credit Inflation. Without a powerful confluence of “stabilizers,” there’s no way market confidence would have remain anchored through an occasionally tumultuous (i.e. 1994, Russia, LTCM, 9/11) $200 Trillion plus derivatives market expansion.

Importantly, the greater the growth and marketplace dependency on derivatives (hence dynamic/trend following trading strategies), the more mandatory it is for the Fed to oblige the marketplace with The Ultimate Big Government Stabilizer Guarantee of Liquid and Continuous Markets. Inherently, markets are fundamentally neither consistently liquid (always buyers willing to accommodate sellers) nor continuous (uninterrupted market pricing where trades are transacted with only minimal impact on prices). This remarkable marketplace subterfuge today plays a momentous role in fostering the ongoing massive Credit Inflation necessary to sustain a Ponzi Finance Credit System, one built upon an edifice of asset Bubble and leveraged speculation-based Debt Structures. To be sure, what has evolved is one of the most bastardized “market”-based systems imaginable.

It was Minsky’s view that “inherited debt reflects the history of the economy.” Today, then, the propagation of asset inflation and serial Bubbles is a dire consequence of a maligned Financial Structure. Cumulative Debt Structures – replete with layer upon layer of borrowings collateralized by inflated asset prices and underpinned by over-liquidity created through the process of leveraged securities speculation – is patently “Ponzi Finance” in character. The market’s optimistic perception and valuation of this Debt Structure, however, remains subjected to ongoing Credit Bubble and “big government” pricing distortions.

I have written extensively in the past on the idea of The Moneyness of Credit. Well, it is “big government” and the corollary Derivatives Bubble that continue to transform endless increasingly risky (“Ponzi Finance”) loans into money-like instruments relishing in virtually insatiable demand. What this entails is nothing short of a complete metamorphosis of risk. Not only does the moneyness nature of current Debt Structures exacerbate debt expansion and the Availability of Credit generally, it greatly distorts risk-taking, the nature of risk, the dispersion of risk, and asset pricing throughout the system.

This week’s housing sales data and today’s news of mortgage problems at H&R Block provide further indication of mounting woes for the riskier segment of residential real estate lending. Perhaps this will prove the initial tumult at the periphery that eventually precipitates trouble at the core. As Minsky expounded with respect to short-lived Ponzi financing units: “Feedbacks from revealed financial weakness of some units affect the willingness of bankers and business to debt finance a wide variety of organizations.”

And I do appreciate that this is how finance is supposed to function – how it’s functioned in the past and how it will again function some day in the future. But I also recognize how contemporary finance has come to view heightened financial stress as among the best opportunities for “big government” to fashion heightened Financial Sphere “profits” (and Lord knows there’s quite a captive audience). For sometime now, the “feedback from revealed weakness of some units” has not been traditional risk aversion, but instead the willingness to position risk portfolios for a lower cost of funds (reduced “pegged” interest rates) and heightened marketplace liquidity.

To suggest we’re facing considerable crosscurrents is today an understatement. Housing and riskier mortgages are deservedly under the radar screen, while market yields at home and abroad are declining meaningfully. For many sectors, markets, and economies these days demonstrating strong inflationary biases, looser financial conditions are undesirable and likely further destabilizing. To what extent this ongoing Monetary Disorder in the near-term precipitates the emergence of latent U.S. Debt Structure fragility is decidedly unclear. But, in the words of Hyman Minsky, “processes which transform a stable system into an unstable system” – having been nurtured for too many years – now grow only more robust and intransigent.

Disclaimer:

Doug Noland is not a financial advisor nor is he providing investment services. This blog does not provide investment advice and Doug Noland's comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. The Credit Bubble Bulletins are copyrighted. Doug's writings can be reproduced and retransmitted so long as a link to his blog is provided.